Compensation Matters

“Perhaps the most important rule in management is ‘Get the incentives right.’”
— Charlie Munger

If you don’t know, Charlie Munger is Warren Buffett’s long-time partner and Vice-Chairman of Berkshire Hathaway. And if you haven’t read his book, Poor Charlie’s Almanack, I cannot recommend it enough. It’s more about psychology and general life advice than it is investing, but it nonetheless had a major positive effect on my investing career. Mr. Munger ends his book with a discussion of 25 psychological tendencies he feels are the most common sources of human misjudgment. The first one on his list, because he feels it’s the most underestimated, is what he calls “reward and punishment superresponse tendency.” In more normal speak, “incentives are extremely powerful.”

On a regular basis I am shocked at how many investors will write about a company and not mention management pay. It is one of the first things I look at and is, in my opinion, one of the most important (and overlooked) parts of an investment thesis. It is human nature to be selfish and act in one’s own interest and many CEOs are incentivized not to act in the best interest of shareholders.

If a CEO owns a small amount of stock and is paid a bonus based on revenue growth, he or she is most likely going to grow the company at all costs. This encourages things like taking on lots of debt to fund growth which hurts the bottom line (and the stock price). On the other hand, a CEO who owns a lot of stock and whose bonus is based on profitability is more aligned with shareholders.

If only it were that simple. While management that owns a lot of stock is great for shareholders, if the CEO owns over 50% of outstanding shares he or she can easily overpay themselves with little fear of being thrown out by activist investors. Even a bonus plan based on profitability can unfairly reward managers who are simply enjoying the benefits of a peaking cyclical industry or a large one-time purchase order. Managers should be rewarded when success is a result of their decisions, not simply being in the right place at the right time. This is a very difficult task and I’m not sure any compensation package is perfect, but below are a few elements of pay packages that I love.

Violin Memory (VMEM) – Kevin DeNuccio, CEO, took over in February 2014 and requested to take his entire salary and bonus in shares of stock. Violin is required by law to pay him minimum wage so now he is making $10.15/hr and the rest of his income gets paid in stock. Several other Violin executives followed his lead and are now taking their incomes in stock as well. This shows a serious vote of confidence in the company and its stock performance going forward.

Consolidated-Tomoka Land Company (CTO) – John Albright, CEO, took over in August 2011 and was granted 96,000 restricted shares that vest(ed) in tranches as CTO’s stock price increases from $36 to $65. Earlier this year he was granted more restricted shares with the final tranche vesting when CTO’s stock hits $90. This is the exact incentive shareholders want to see in the CEO’s pay package.

XPEL Technologies Corp (DAP.U) – Executives and directors all own lots of stock accompanied by low salaries. Ryan Pape, CEO, made $251,408 in 2014. Compare this to the 1,363,602 shares of XPEL’s stock he owns that is currently worth $3.5 million. Owning stock that is valued over 13x his total annual income encourages him to act in ways that increases the stock price and thus aligns his actions with shareholders. I mention the ratio of CEO stock ownership to his or her total annual income in all of my investment write-ups for a reason.

Some investors think all stocks are investable at a low enough price—I strongly disagree. I am very strict on shareholder friendly management—any red flag is an automatic pass for me, no matter how cheap the stock is. Investing in CEOs that are taking advantage of shareholders or are simply not incentivized to act in shareholders’ best interest is an uphill battle. There are tens of thousands of public companies in the world, why invest in managers that aren’t sitting on your side of the table?

Note: All of this assumes you are a relatively small, passive investor like myself. Activist investors probably look at a horrible compensation package and see opportunity 🙂

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4 thoughts on “Compensation Matters”

I can understand how it might be wise to avoid investing in many, or even most, seemingly cheap companies, when they have unfriendly managers. But I don’t understand how you can say that some companies are uninvestable at any price.

Imagine a public company where management is very unfriendly to other shareholder but which is super cheap: let’s say it’s one with no operations, no liabilities, and no assets other than $100 million in a checking account at a bank. The CEO, it’s only employee, owns 60% of the company, and pays himself $500k per year for doing nothing. He’s been caught stealing several times in the past. He doesn’t hold annual meetings, and when other shareholders call him he swears at them and hangs up the phone.

If you were offered 10% of this company for $1, wouldn’t you buy it?

There surely is, in the next 10 years, at least one chance in a million that the CEO changes his ways, dies, etc., and so the expected value of your bet is much superior to your $1.

Yes I would take that bet, but that doesn’t disprove my stance on uninvestable management teams. Unfortunately the market doesn’t serve up opportunities as simple as that one. It really comes down to the fact that I like investing in companies that don’t keep me up at night. I’ve invested in unfriendly managers before and I quickly realized it wasn’t for me. I spent more time worrying about those companies than all my other holdings combined. Knowing the CEO has the same end goal as me helps a lot with that.

I read through Allen Mecham’s shareholder letters recently and in one of them he talks about how he passes on +EV situations all the time. The reason is he (and all investors) are bad at handicapping investments. With respect to managers, I think it’s too easy to let a really low P/B (or whatever metric it is) overshadow how much damage a bad manager can actually do.

SODI is a good example that I was briefly invested in years ago, but sold out of for these very reasons. Super cheap company with a very unfriendly CEO. Activists are finally making some inroads recently, but they still have a ways to go.

I agree that opportunities like the one I described don’t present themselves in real life. However, I seems to me that the thought experiment shows that all companies are investable at some theoretical price.

You say, rightly, that it’s “too easy to let a really low P/B…overshadow how much damage a bad manager can actually do”. I agree, and if you are in the business of having concentrated positions in quality stocks, like Allan Meecham, it might be smart to invest only in companies with good managers.

But if one doesn’t have Allan Meecham’s brains and is trying to make money from a diversified group of quantitatively cheap companies, the opposite argument could be made: it’s too easy to hurt your results by rejecting a company for qualitative reasons like management friendliness, because often the qualitatively ugly companies (perhaps because they look ugly to most people), are the cheapest.

Like other qualitative factors, the quality of management is subject to mean reversion, and thus a way for patient value investors to make money. SODI might end up being an example of this, or not, but I think owning 100 SODIs would likely work out well.

I agree owning a lot of SODI types is probably a good strategy (just look at Walter Schloss). SODI would have made me some money if I held onto it, but I’m happy with my decision to sell.

I do run a very concentrated portfolio by the way. My philosophy doesn’t mean other strategies are wrong, I’ve just tried to find one that fits my personality. There are many ways to skin a cat after all.

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This blog is for informational purposes only. Everything on this blog is the opinion of Travis Wiedower and should not be taken as investment advice. Clients of Wiedower Capital may maintain positions in securities discussed on this blog.